It may not come as a shock to you, but loan officers, along with many other salesfolk, speak a different language than the rest of the population. What will probably annoy you, however, is the number of times they’ll say something that sounds like a phrase out of English, but really is from Salesgoodspeakian, a bizarre Orwellian tongue in which the true meanings must be learned by osmosis from the particular subculture’s dialect, while intending to communicate something entirely different to the poor schmuck who, after all, doesn’t understand salesgoodspeakian.
This post is intended partially as humor, partially as education. I’m going to start it with a few of the most common ones, and update it by adding more and reposting from time to time. If you’ve got a good one, either with or without translation (and whether from one of my fields or not), please send it to me along with the context, if appropriate (dm at). Even if you don’t have a translation, I’m pretty good at major dialects of salesgoodspeakian. It is to be noted that these phrases are not red flags, but more in the nature of yellow flags. If they just occur on a stand-alone basis, it’s something that’s likely to proceed from yellow to a red flag, particularly with repeated yellows. On the other hand, if the person uttering them proceeds to issue a clarification in plain English, issues an amplification rendering the translation void, or translates and explains the salesgoodspeakian, it’s possible you’ve just been given a real world green flag that this is an ethical person. For instance, my absolute favorite loan to do is a true zero cost to the consumer A paper loan (and no prepayment penalty!), which I usually explain as “Nothing added to your mortgage. You’ve just got to do the paperwork with me, and come up with the money for the appraisal, which will be returned to you when the loan funds”. And it’s also possible you’ve been given a reinforced red because they lied.
And yes, I’ve had clients who came to me report every one of these. Some of the translations are a little exaggerated to make the point, but the spirit remains the same.
The salesgoodspeakian to English phrasebook:
Mortgage dialect:
“Stress free loans” two percent higher than you’d qualify for with better documentation and a little more work and less greed on the loan officer’s behalf.
“Won’t cost you anything out of your pocket” – Six points and $5000 in well-padded closing costs added to your mortgage loan balance, though.
“Thirty Year Loan” fixed for the first two, if they’re feeling generous that day, but it does have a thirty year amortization. With five year prepayment penalty of course!
“How does a 1% rate sound?” Like you’re a misleading weasel trying to get me to do a loan that digs me in deeper every month with a three year prepayment penalty that keeps me trapped even after I figure it out (See Negative Amortization Loans when I get that finished)
“Industry standard” – Everybody else at this company does it that way, too, because the boss says to, and I don’t know any better. (This is very much the “G” rated translation. Please note that there are industry standards – things that pretty much every company in the industry does. Some of these standards need to change, some just are, and some are actually beneficial).
“Everybody knows there’s 2% origination fee.” Actually, everybody knows no such thing. But if I told you about it in the first place, you might have gone with somebody honest.
Found on the same billboard:
“Rates as low as 4%!” on an “adjusts every month” loan that’s going to 6% next month and who knows what thereafter. With five points. While I have you on the phone, let’s sign you up for it.
“No Points!” we’ve got no points loans. Not on the loan we quoted above. I’m really so terribly sorry you misunderstood. Now, about that 4% loan, what’s your name?
“Low Fees!” compared to the multimillion dollar Oil For Food bribes, $23,000 is low. Now about that 4% loan, what’s your social?
“Easy paperwork” but the start rate goes to 6% for the first month, adjusting to 8% next month. Still five points. Not for the rate we quoted above. I’m really so terribly sorry you misunderstood. Now, about that 4% loan, when can you come in to sign?
Caveat Emptor
Pre-requisites of Investing
It shouldn’t surprise anyone that there are things you should do before you make your first investment. The SEC, NASD and all of the various other financial planning organizations all explicitly list three things that should be in place in most cases prior to making your first investment in anything.
The first of these is an operating reserve. This is a fund of ready cash outside of any investment account, that you can use for emergencies. The minimum is three months of your normal expenditures, but six months is better. People lose jobs, have accidents, have health problems, things come up – you get the idea. Unless your job is rock steady, your cash flow predictable, and you can live on less than fifty percent of your take home pay, you really want to have living expenses for six months saved up, and for some self employed situations where your cash flow is uneven (like say, financial planner or real estate), twelve months is better. Having this much cash on hand gives you a certain security, and you likely won’t have to cash in your investment for some minor emergency.
The second of these is a life insurance policy. This isn’t from any deep-seated desire to sell you a life insurance policy. Investment professionals have only been getting insurance licenses since about 1980, and this recommendation is far older than that. Almost everyone is going to need a life insurance policy at some point in their life, and it is cheaper and more effective to purchase while you are young. As I’ve found out, sometimes things happen to you that prevent you from obtaining life insurance (as in no company will issue you a policy, or will only do so on prohibitive terms), and if you want a family eventually, it is wise to take care of this now. Furthermore, certain life insurance policies are among the very best investments you can make, and more effective the sooner you start them. This is not to say that life insurance is for everyone. I have a client who’s older, has no dependents and never will, has plenty of assets to cover final expenses, and those assets are titled so that they will pass immediately and correctly to his heirs. A life insurance policy would still be of benefit if he had certain goals, but he doesn’t. So we’ve decided it’s not for him.
The third of these is estate planning. This is actually in the requirements as a will, but there are other elements such as durable power of attorney for health care, living trusts, and so on. These do cost a certain amount of money, but it’s money well spent. If something happens to you without doing this planning, every state in the US has a different law as to what happens to your assets, your minor children, your pets, etcetera. These are all cookie cutter approaches, and that cookie cutter was likely enacted a long time ago, to where the assumptions that the legislature made at that time are no longer valid for large numbers of people. The majority of your assets should not be transferred by a will, anyway – wills can be and are challenged successfully every day. Trusts are far better.
If the person you work with is any kind of financial planner, they should add two additional concerns to the list. They are disability income insurance and long term care insurance. The need for both goes away as you become more affluent. Remember, that insurance companies exist to make a profit and if you can afford the risk of losing what they insure, you shouldn’t buy a policy. So if you’ve got a couple million somewhere, and if you never made another penny you would be comfortable, there is no need for disability insurance. The same applies to Long Term Care, albeit probably requiring more affluence. Average per diem billing in California is $240+, with another $60 or so in supplemental charges. So when you can afford $300 per day (about $110,000 per year) for a period of several years in addition to what ever else you may need for your family to live, you are not a good candidate for this. On the other hand, long term care facility prices keep rising, and as medical capabilities for keeping you alive get better, you can expect to spend longer in such a facility.
(For all the money and research we throw at prolonging lives, you’d think we could spend more on making it a robust life, or allocate more of what we already spend towards that end. More and more, we are statistically tending towards living longer in an increasingly frail, helpless and joyless condition. As long as people are enjoying life, more power to them. When it becomes a miserable painful existence, as I have seen too much of, I just don’t see the point. When I see what so many people put themselves or their loved ones through, I’m making certain I’ll always have a “check out” option under my own control, and if I don’t have control to exercise, my wife and I are agreed that neither one of us wants to hang around).
Islam, Historical Christianity, and Reform
Done With Mirrors had a post that gave me the idea for this, and alerted me to an excellent article illuminating the subject at Donklephant
I want to compare and contrast the history of Islam with that of Christianity.
Christianity was founded in a time of a strong civilization and empire. At the time of Christianity’s birth, Rome was not merely the strongest polity in sight – her might was unchallengeable. By the time of the actual Roman conquest in 63BC, Rome had already been the power broker for the whole eastern Mediterreanean for a century. After Actium and the Egyptian conquest, there was no power capable of challenging Rome anywhere around. Military conquest wasn’t just out of the question; it was so far fetched as to be ridiculous. If it was a dream (and it was, a fact of which the Romans were well aware, which made the area completely unremarkable as far as the Romans were concerned), it was a dream clearly beyond reach for now.
It was into this situation that Christianity came into being. Certainly, given a chance, worldly power has always been one of the aims of any priesthood. However, military solutions were out of the question, and so the holy writings of Christianity, while certainly conducive to forceful conquest, emphasized individual faith, individual missionary work, and the powers of persuasion rather than of forcible conversion. In its early years, Christianity’s story was a story of persecution, of hiding in the shadows, at first from the entrenched Jews, later and more importantly from the Romans. Now, the degree to which they were persecuted by the Romans is frequently exaggerated by the Christians. But if they didn’t have to worship quite in secrecy, they were unable to worship publicly, much less forcibly convert others.
When Christianity became the official religion of the empire in Constantine’s reign (the preceding persecution by Diocletian being one reason the meme is so entrenched in the religion), it certainly had no problem with conversions by means other than persuasion (followers requiring conversion for advancement, among other motivations). But the roman empire was soon on the wane. First invasion ended the western empire, then Christianity found itself under attack from the north (Viking raiders), east (the Byzantines were in a war of survival from the eighth century onwards), and west (the Iberian peninsula was conquered), as well as riven by internal conflicts between church and state (beyond the scope of this essay, but consider the conflicts between the Fredericks of the Holy Roman Empire and the papacy.) These conflicts became the hothouse that bred the Renaissance and technological advances, and as soon as the Europeans figured out that there was a whole world out there a lot easier to conquer than their fellow Europeans were, they took advantage of it. Nonetheless, by this time the groundwork had been laid for some tolerance of religious differences, and by the time of the Peace of Westphalia this had been solidly grounded, at least in regards to religion not being used as a justification to invade other states.
So by the time of the colonial period, the rights of the various Christian sects to coexist had been basically accepted. If some were not encouraged or accepted so much as others by a given state, at least there was a level of tolerance between sects won on the battlefields of Europe. Later, even non-Christian religions became more accepted in Europe, and even the predominantly European colonies such as the United States and Canada. There are limits, strong limits with strong historical precedent, to the imposition of Christian faiths. Conquering the heathens and bringing the faith to them were regarded as two separate items upon the agenda, and if they were often prosecuted at the same time and one often used as an excuse for the other, the part about bringing the word of god was regarded as an opportunity for the natives, not as a mandatory “convert or suffer the consequences” sort of thing.
Islam was born in a region and era when the city state dominated. There was no overarching, overwhelming worldly power that could not be challenged. As a result, Mohammed was able to build in a large component of “spread the word upon the point of a sword.” Mohammed drew a much starker line between believer and non-believer than the early Christians would have been able to consider. Whereas in the Christian worldview, there are those that believe and those who have a chance to convert and be saved. God and the church are not one in the christian worldview. There is very little of this distinction in Islamic thinking.
The very name Islam translates as submission – submission to the will of god as dictated by his priests. Islamic priests. The concept of the person completely outside the faith does not enter into their thinking, as it does with Christianity as evidenced in Dante’s Inferno, among other classical references to “virtuous pagans,” who may have been good men and so are not punished, but are not admitted into what Christians see as god’s grace in the afterlife. The Islamic worldview divides starkly into those who have submitted to the will of god, and those who have not. Those who follow the word of god through his priests must follow the teachings or be damned unto the realm of Iblis. Islamic rulers are in many ways puppets of the priesthood. If the priesthood says that a certain act is against the teachings of Islam, then it will not be allowed.
The concept of the missionary – a preacher who converts the unbelievers by persuasion, rather than at the point of a sword, was present in Mohammed himself, but at no subsequent time in Islam until the modern era. Whether westward from the Arabic peninsula into the (then Christian) north coast of Africa and thence into the Iberian peninsula, north into what was Christian territory in modern day Turkey and thence into central Asia, India, and into present day Indonesia, Islam was brought and enforced at the point of a sword. Existing religions in conquered areas that qualified as “peoples of the book” (Christians, Jews, and Zoroastrians) were not quite forcibly converted, and dealt with fairly up to a point, but were still (and are still) subjected to extra taxations as well as limitations upon their right to practice their religion, ability to advance outside their narrow community (The famous Alfred Dreyfuss would never have been permitted to serve an Islamic power, nor Benjamin Disraeli to hold his office. Israel, hated and vilified as the enemy of all Islam that in their media, has Islamic parties in the Knesset and Muslims throughout the government, including upon their Supreme Court), and flatly prohibited from making converts (As witness the Saudi treatment of Christians). It is to be noted that unlike Christianity, Islam has nothing analogous to excommunication or walking away from the faith. It is simple to become a Muslim – their simple profession takes less than ten seconds, and can be stated anywhere, anytime. But at least within the eyes of Islam, it is impossible to sever yourself from it. Once you take the pledge, you are bound forever in their eyes. Christianity, at least in theory, has always had the ability to leave the faith. In Islam, it is not even a theory. Once you make the profession of faith, you are Islamic forever, and the priests will always have dominion over you. You may be a heretic or apostate, but you are never beyond the reach of the priests, who understandably consider the cessation of practice as a matter to be urgently addressed. As an outgrowth of this, once an area is Islamic, it must forever more be considered Islamic in their eyes.
Islam, in short, does not have the historical limitations of proselytization placed upon it that Christianity does. Whereas Christian doctrine requires a good Christian to treat with all persons in good faith so long as they act in good faith, Islam does not. It has only the concept of a grudging truce between believers and non-believers, and this must only be done when there is something to be gained thereby (for instance, the Israelis do not conquer Damascus, Cairo or Baghdad within the next few weeks). In such instances, Islam permits its practitioners to make truce, and even to pretend it is permanent, but not for it actually to be permanent. As spoken by Islamic leaders from the very beginning to the religion and continuing today with every notable modern leader, the only permanent “peace” countenanced by Islam is when all the non-believers have been converted. Check out the translations provided by MEMRI for all of the evidence as to this which you should need. But the truce is exactly that – a breathing space meant to allow the Islamic soldiers time to force a more favorable situation, which they will then use to resolve the conflict in their favor. They are not giving up. Their religion does not permit them to give up. It’s only one more way to continue with the conquest of the dar-al-Harb.
Indeed, this situation is written into the Koran itself in ways which put the Old Testament to shame. Whereas the Israelites conquered themselves a homeland and proceeded to defend it, the Koran writes conquest and conversion into the very fabric of the religion, as from Mohammed’s days forward they were a religion of conquest. It is not clear to me that there is an available mechanism to change this. Unlike Christianity, it is the explicit injunction of the Koran that Islam value the pronouncements of living priests over that of dead ones, but this does not extend to the pronouncements of Mohammed, whence all of the Koran flows. Since it is with the pronouncements of Mohammed that we, the civilized west, have issue, we must accept that there may not be a way short of the extermination of Islam to permanently resolve the issue.
There are, to be certain, what we would call moderate Islamics. There is even, in modern Turkey, a secular state dominated by Islam. However, the continued existence of Turkey as a secular nation has been anything except easy since it’s creation after World War I. It has several times required the Turkish army to support governmental change or even to take over and run the country itself. I do not know how the meme that “Turkey is a secular nation” became engrained in their army and officer corps to the extent it has, but would be fascinated to learn it, if someone can point me at a good source or six. The process whereby it occurred could bear serious examination with an eye to adapting it elsewhere.
But despite the singular example of Turkey, the rest of the Islamic world remains locked in a jihad mindset, which if somewhat analogous to the Christian crusades on medieval times, both predates it and is much stronger in both religious and cultural senses of the term (Christians have always believed that a crusader who is evil will be banished to realms of punishment in the afterlife. Muslims do not and never have; the act of jihad is, in itself, a redemption). If individuals do not wish to join the jihad themselves, they are nonetheless required to admire and support those who do. Jihadists are to be allowed to preach, to convert, and to recruit. To do otherwise is contrary to the teachings of Mohammed, and woe betide the secular leader who wishes to hinder it, as the Saudis are discovering right now.
For us to win the war on terror without necessarily exterminating all Muslims, this has to change. And this reform can only come from within Islam. I have seen a few encouraging signs, but not nearly enough.
For those of Islam reading this, I do not wish a war of extermination between us. Despite all of the problems I see with Islam, it has aspects of tolerance and moral teaching lacking in many other faiths, including Christianity. I would like to see a broader understanding of your faith worldwide. But it must be done by the peaceable exchange of ideas, and those of other mind must have equal opportunity to convert you to their point of view. Your co-religionists cannot be permitted to continue jihad, and if you conspire with and support them, I must consider you their ally. It is not enough that you remain silent. You must remove the doubt that silence allows, and stand with the forces of civilization and tolerance for all, or with the forces that wish to bring the world back under the dominion of a priesthood that still has not left the dark ages behind. If you stand on one side, you will be among our most valued citizens. If you stand on the other, giving us a choice between submission and a life lived according to precepts that hardened in the eighth century, or death, then you must be stopped. All we ask is that you forswear the idea of conquest in the name of your religion. This is something that every other major religion has managed. It is now your turn.
Housing and Urban Development Form 1 (HUD-1)
I have mentioned this form several times in the past as the only form in the entire mortgage process which is actually required to be accurate. Whoever your provider is, this is the one form they cannot play games with. This article is goes over the form line by line, referencing previous entries.
The top section has to do with identifying information on your transaction. Your name, the name of the other party to the transaction, escrow numbers, name and address of lender, date of settlement.
The meat starts with line 100, the Summary of Borrower’s Transaction, and line 100 the section on Gross amount due from borrower.
101 Contract Sales Price: Should be the same as on your purchase contract.
- Personal property: Say you agree to pay $500 extra if they leave the sofa. Here’s where that goes.
- Settlement charges to borrower (line 1400) adds the costs of the transaction to the total.
106 and 107 are repayments for any taxes the seller may already have paid as of the date of settlement, but are not their responsibility as the time period covered includes some time after the effective date of sale. - Adds all the lines up to this together. The rest are simply blank lines that may or may not be a factor in your particular transaction. If they are a factor, it should be because you specifically agreed to pay them!
The 200 section is about stuff that is paid for, or on behalf of the borrower, or you have simply already paid. - Deposit or earnest money: The deposit you made, either with escrow (purchase) or the bank (on a refinance) to persuade them that this was a good transaction.
- Principal amount of new loan(s): Check and make sure this matches your new Note. In some states, they may be able to combine the amounts of two loans here, but they shouldn’t.
- Existing loans taken subject to: If you’re assuming a loan or something similar, it goes here.
- Second mortgage loan: Compare against your new second mortgage amount.
205 and 206 are blank lines for things that may not be a factor in every transaction.
210 and 211 are for city and county taxes that have not yet been paid by the seller, but the cost has been incurred. Let’s say today is September 1, and we’re in California, where the property taxes run July 1 to June 30. On September 1, the seller owes two months of property taxes, but those taxes haven’t been paid, and won’t be due until November 1. So there will be a credit here from the seller to the buyer for two months of property taxes, which the seller is responsible for until the effective date of sale, but the buyer will have to pay on November 1. 212 to 219 are blank lines unless something special is relevant to your transaction.
220 is total paid by/for borrower: This is a total of everything paid by you or on your behalf.
300 Section tells if you are due money at settlement or have to come up with some. 301 is transferred from line 120, 302 from line 220. If 302 is larger, you get cash back. If 301 is larger, you have to provide the check in otder to close.
The second column is a summary of the seller’s transaction, if there is a seller and it’s not just a refinance.
Section 400 is about what’s due to the seller, starting with 401 Contract Sales Price, then 402 which is a mirror or 102, then 403, Impound Credit, which is rarely used, as it is pretty much applicable to loans being assumed.
406 and 407 are mirrors for 106 and 107, as are 408 to 418 mirrors of the 108 to 118 section. 420, Gross amount due to seller, is a summation of all of these.
The 500 section has to do with stuff the seller is paying other people.
501 is excess deposit, 502 is settlement charges to seller, 503 is loans that are bing assumed.
504 and 505 are mortgage payoffs being made, 507 through 509 are blank spaces for things not applicable to every transaction.
510 and 511 are mirrors of 210 and 211, as 512 through 519 mirror 212 through 219, blank lines not applicable to every transaction.
Section 600 is analogous to but not mirroring section 300. Line 601 is line 420 brought down. Line 602 is line 520 brought down. The difference is line 603 cash to seller (This can be line 603 cash from seller in the case of a so-called “short sale”)
All of this is good and necessary information, but The Really Good Stuff™ is all on page 2. The lines at the right list who is paying it (buyer or seller)
Section 700: division of commission
Line 701 is compensation to the listing broker, line 702 is to the selling broker (i.e. the buyer’s broker, the people who “sold” the property), and line 703 total commission paid at settlement. I’ve never seen this paid by buyer, it’s always been paid by seller.
Section 800 is items payable in connection with the loan itself. This doesn’t mean that these are all the loan-related charges – far from it.
Line 801 and 802 are dollar amounts of points. If these aren’t zero, divide them by the loan amount to make certain they are the numbers agreed upon.
Lines 800 through 1317 are linked on a 1:1 basis with the appropriate lines on the Good Faith Estimate (Mortgage Loan Disclosure Statement in California) (see articles on Good Faith Estimate linked below for explanations) In an ideal world, the total of these should be exactly what was indicated on the Good Faith Estimate/Mortgage Loan Disclosure. There are some few items that are not under the loan officer’s control (again, see Good Faith Estimate for which are and are not). A good rule is that if it isn’t on the Good Faith Estimate/Mortgage Loan Disclosure in one form or another, it shouldn’t be here. Compare it to the Good Faith Estimate/Mortgage Loan Disclosure to find discrepancies. Other than things like prepaid interest, which the loan officer does not control but should have a pretty accurate estimate of, the most difference there should be between the two documents is one big fee gets broken down into little fees. But if you’re told, for example, that the $795 amalgamation of lenders fees was broken up into A, B, and C, make sure that A+B+C=$795, and do not allow additional fees to be lumped in. Grab a piece of scrap paper and take notes. Make certain these numbers jibe. It is easy to hide thousands of dollars in unsuspecting fees to clients in this page if you, the client, are not careful.
Line 1400 is a summation of these lines.
Once again, look hard at the numbers on these two pieces of paper. It is the only honest accounting many people get of the transaction, and the fact that it comes at the end of the transaction makes hiding all kinds of things easy. You, the client, are tired of the whole process and want it to be over, a fact which many loan officers and loan providers rely upon. Put your guard up for a few more minutes, long enough to be certain what you sign for here matches what you signed up for back at the start of the process.
Caveat Emptor
What You Should do at Closing
I’ve said upon more than one occasion that the factors at closing are all in the loan provider’s favor. The typical consumer has no leverage to get the loan provider to play it straight at closing, and actually deliver what they said they would back when you signed the application. Many people never notice that their lender has taken advantage of them until they get the first payment notice, which is far too late to do anything about it. Furthermore, others never notice at all, and of the ones who do notice something is wrong in a timely fashion, eight to nine out of ten are so fed up with the loan process that they sign the documents anyway. I keep hearing sworn oaths from people who signed up with my competitors that they won’t sign the documents at closing if they’re not what they were promised, yet when I follow up the vast majority of them did. I can only conclude that these people actually enjoy being lead on like the rats by Pied Piper of Hamlin.
Assuming that you are not one of those people who enjoys being treated like a disposable rat by someone who’s making a goodly sum of money from your business, what can you do? The first thing is apply for a back up loan. As I say elsewhere, if you’ve got a back up loan lined up, you’ve got leverage. Your options are not limited to sign these documents or don’t. You can sign the other provider’s set of documents, and the person who lied makes zero. Or you can use the existence of an alternative to get both companies, if need be, to give you the loan you were promised in the first place.
But how can you tell if you’ve been treated right by the loan officer? There are dozens of pieces of paper that get pushed in front of you at signing. Disclosures for this and disclosures for that. Truth in lending statements. Yet more disclosures. Certificates good for a discount here and a discount there. This is partially legal requirement, partially intentional on the part of loan providers. There really is a legal requirement for most of these disclosure documents, but the loan provider likes that they are there because they all distract your attention from where it needs to be focused.
There are three documents at the heart of every loan closing. They are the Trust Deed, Note, and Department of Housing and Urban Development form 1 (HUD 1). I advise reading everything, especially any title transferring documents, so the lender cannot easily throw a curve in amongst the auxiliary documents. But most don’t bother trying. The three main documents are where you should be focusing your attention.
Sometimes, the Note is included in the Trust Deed, but most of the time they are stand-alone documents. The Trust Deed gets recorded with the county, while the Note usually does not. Some states that I haven’t worked in may use other systems (A Mortgage Note, for instance, which needs an actual court action in order to foreclose, and which California along with most other states have gotten away from because it is more costly).
The Deed of Trust is simple enough. Look over the Deed of Trust enough to see that it properly references and does not contradict the Note.
The Note requires more attention, and cross referencing between it and the HUD-1. Is the amount borrowed consistent with what you were lead to believe? Is the rate correct? Is it fixed for the correct amount of time? Is there a prepayment penalty, and if so, for how long? Check out the repayment terms, and make certain there are the payments are what you were lead to believe. The Note is what you are agreeing to by signing all of this paperwork. Make certain it reads the way it is supposed to. Take your time, read it over, do not allow yourself to be rushed. Do not think to yourself, “I’ve got three days to call it off” because once you are done signing the odds are long that you will not think about your loan further until your first payment becomes due, and that is too late. Read it now. If there is anything that you do not understand, ask for a clarification. Good clarifications start from a point of the wording that’s on the paper, and make easy sense in English. Do not accept a clarification that you do not understand. Do not sign hoping to get a better clarification later. Do not sign period if you aren’t certain you understand.
Check out the HUD-1. I’m working on a separate post to cover all of the issues there, but make certain the costs are what you were led to believe, and that it all adds up correctly. The numbers should start with the Old Loan (if Refinance) or purchase price, plus costs, plus reserves if you’re doing an impound account, plus prepaid interest, minus any money you’re bringing in (down payment, etcetera) or the seller or your broker is crediting you, and that should be the balance of the new loan. Take your time with the HUD-1 and the Note, and do not allow yourself to be rushed. Do not sign until you are certain that you understand and agree. If this takes a little longer than the signing agent planned for, tough. Many loan providers are adept at distracting you with this disclosure or that disclosure. Some companies actually provide them with training in how to distract you, and how to gloss over thousands of dollars that you didn’t agree to. Stick to your guns. The Note is what you are agreeing to, the Trust Deed is there to enforce it, and the HUD-1 is the only form accounting for your money that is actually required to be accurate. The Note, Deed of Trust and HUD 1 are what the lender is going to force you to comply with in a court of law. Make certain that they are what you agreed to before you sign them. If they’re not, well that’s why you applied for a back up loan, right?
Caveat emptor
The State-run 529 Plan
Of all the investments out there available to be made, the 529 is neither best or second-best, but it is right up there near the top.
Back when I was actively working in the financial planning business, it was one of the easiest to sell, as well. It holds one of the best sets of tax advantages, and is surprisingly flexible for something designed to fund a college education.
The 529 works in relation to the IRS’s gifting rules, and is subject to those and other limitations. There is a limit, that varies from year to year, on the maximum total contributions. However, it has a couple of powerful benefits that most investments do not have.
First off, you can front load it with up to five years worth of gifting contributions. With this currently at $18,000 per year, this means that an individual can give up to $90,000 and a married couple up to $180,000 all at once.
Second, any investment income earned by the 529 is tax deferred until you take it out. So you’re earning interest on any money you might otherwise have paid as taxes until you actually make a withdrawal.
Third, you, the donor, retain control over the investment, and can transfer it to another donee if your initial pick decides to skip college or wants to buy a motorcycle with the money. With most account forms, such as the Coverdell, that money is theirs, totally and irrevocable, on their 18th birthday, and they can sue you for it. The 529 is the only account I’m aware of with this reservation. You can even recapture it for yourself in many circumstances, if you decide to.
With estate tax gone, the fact that investments in a 529 are no longer part of your estate is less important, but 529s pass with full tax deferral, immediately and outside of probate to named successor owners or beneficiaries, as applicable, and they have the option to keep them going rather than taking the money. Most other investments do not afford anyone except a spouse this opportunity to keep the account going as it was.
Finally, if you use the money for college or college related expenses, the withdrawals are tax free. Even if you don’t, the penalty is only ten percent of earnings, which is much smaller than, for instance, the Traditional IRA. Other neat facts: No matter where you live, you may use any state’s 529 program, and go to college in any state you like, and still enjoy the full benefits.
Let us consider, hypothetically, the case of a 60 year old with a 40 year old child. Not too many children go to school, but the 529 can be useful even so. Suppose the 60 year old has $50,000 they don’t think they’ll ever need, and they want to make certain the 40 year old gets it when they die, but wants to keep control of the money in the meantime, and wants a lot of bang for their buck.. Consider the hypothetical of a 9% yearly return, every year. The 9% return is likely to be slightly low on the average, and the stock market never returns a consistent figure from year to year, but let us consider it. Suppose the parent lives 20 years. That $50,000 has turned into $280,000, same as a traditional IRA. But now the child has the option of keeping it going, which they do not have if it’s in a traditional IRA, and they only have to pay tax on $230,000 if they withdraw it all at once. Put into a taxable account, even if it earned the same 9%, and assuming a 28 percent tax rate, it would only be $175,500. Assuming the same 28% tax rate, withdrawing all of it at once leaves them with $215,600. Or they can withdraw it a little bit at a time, to pay for, say, their own grandchild’s college, during which time the remainder continues to earn income tax deferred.
The Pre-qualification
One of the most overworked items in the real estate industry today is the pre-qualification for a loan. Sellers want buyers to be “pre-qualified”, and buyers are seeking “pre-qualification” to convince buyers they are serious.
The level of work done for a pre-qualification varies. In some rare instances, the loan officer doing the work not only runs the credit, but verifies the income as consisting of the proper income documentation paperwork (w-2s and/or taxes, plus pay stubs and/or testimonial letter) for the loan, and determines how much of a payment you can qualify for based upon known income and known indebtedness, and actually includes the assumed property tax due to purchase price in the payment calculations, and gives you an answer in how much you can qualify for based upon current rates at the time. This is a fair amount of work, consuming hours of time. A loan officer at a direct lender who goes through this whole procedure might be done in two or three hours. A loan officer working for a broker can actually take a full day, or even two, making calls to various lenders and shopping the loan around after the primary calculations are done. On real transactions, I’ve gone over two days on multiple occasions, trying to find a better loan.
The pitfalls and caveats are many. If the loan officer doesn’t run your credit, which costs money, they really have no idea what your credit is like. If they don’t verify your income, they are making a giant assumption that what you told them is accurate for purposes of a real estate loan (you get to use gross pay, but there are a multitude of potential adjustments). The payment you qualify for when you actually go to buy a house and get a real loan is a so-called PITI payment, which stands for principal, interest, taxes and insurance. Insurance is always an educated guess, unless and until you have a quote from a prospective insurer on a particular property for an adequate amount of coverage. Taxes here in California will be initially based upon sales price, and unless you live within one of the high property tax areas, is pretty much a set rate for the whole state, but there are many special assessment districts, scattered all over the state. I’ve seen properties with as many as four of these, although many if not most properties have none. It’s much harder in some other states to even come up with a meaningful rule of thumb figure. All of these factors throw the taxes figure off.
Principal and interest – the actual loan payment – is what’s left over from your allowed payment. From this, you can compute a principal loan amount based upon known interest rates.
Here’s where the games really start. The first question is “What type of loan are they basing it on?” The thirty year fixed rate loan always has the highest rate, which means that if they use that as their starting assumption, they are going to be able to “pre-qualify” you for less than somebody else can. What’s the lowest rate? A month-to-month variable or even a negative amortization loan (see link at the bottom of the article). Somebody assuming they are going to qualify you for a negative amortization loan is going to “pre-qualify” you for a larger loan – more than you can really afford. Which is more attractive to someone who doesn’t know any better? That’s right, the latter. Which one does someone who is educated want to drag into the sunlight and stake through the heart? That’s right, the latter. Amazing coincidence? Not really. From personal experience, many people do not want to become educated, even to the level of a competent layperson, and they will get taken for a ride as a consequence. What they want is to look at houses, pick out one they like, sign a couple sheets of paper, and move in. What these people are likely to get is a disaster. Many people in my industry make a very high class living ripping off people like this while setting them up with a gotcha that’s going to bite, and bite hard, but not until after they’ve got their commissions and depart the scene. “How many houses are they going to buy from me, anyway?” is the typical thinking.
One more concern is the fact that while sub-prime loan rates are higher, and in most cases they will have a pre-payment penalty, where A paper loan rates are lower and in most cases do not have a pre-payment penalty. However, the highest payment A paper loans will allow is less than the highest payment sub-prime loans will allow. So the loan officer can typically qualify you for a bigger loan based upon a sub-prime loan. See my article on “Mortgage Markets and Providers” linked below for more information.
Additionally, the rates on loans change from day to day, week to week, and month to month. It takes only a calculator to show that even an honest and complete “pre-qualification” done on a rate that’s valid today may or may not be accurate by the time you actually find a home.
Another game loan officers play is with the rate versus cost and points tradeoff. It is counter-intuitive but true that it is actually easier to qualify someone for a lower rate. If you qualify for a given loan program at 5.5 percent, you will qualify for the same program at 5.25 percent, but you might not qualify at 5.75 percent. The reason is that the payment is (or should be) lower if the rate is lower, and payment is what qualification is based upon. The cost to you is that most people refinance or sell before they have recovered the additional costs of these lower rate loans. (See my essay on Mortgage Rate and Points, which is linked at the bottom of this article for details and sample computations.) So they’re going choose a loan that sticks you with costs you’re not likely to recover, all in the name of qualifying you for a larger dollar amount.
THERE IS NO WIDELY-ACCEPTED STANDARD FOR “PRE-QUALIFICATION.” Let me say that again. There is no widely accepted standard for prequalification. Consequently, everywhere in the nation, but particularly in California and other high cost areas, the pressures on providers to “pre-qualify” you for inflated numbers is intense. If you don’t qualify for enough to buy any home, they obviously don’t have a transaction. If they pre-qualify you for less than someone else, most people are more likely to go somewhere else, and they don’t have a transaction. The competition is qualifying them based upon month-to-month variable loans or even negative amortization, and so if they don’t as well, they don’t have a transaction. Few people qualify clients based upon how things really are, and the easy transactions where everything fits and the people qualify based upon traditional measures are mostly long gone. If they don’t have a transaction, they don’t make any money. The don’t make any money, they don’t stay in business, they can’t make the payments on the Porsche, their house gets repossessed, their wife has to sell her jewelry to keep them off the streets, etcetera. It’s not a pretty picture for them, and it often leads to them putting clients into situations they cannot really afford. Finally, of course, the size of commissions is based upon the size of the transaction, so if they “pre-qualify” you for more, they have the prospect of making more when you buy the bigger house that you cannot really afford.
This doesn’t even go into the issues of a stated income loan. (See article on Types and Levels of Mortgage Documentation linked at bottom of this article). This is where you cannot prove income according to industry standards via taxes, w-2s, pay stubs, or perhaps bank statements for sub-prime loans, so you state your income and in return for a higher interest rate, the bank agrees not to verify the actual income level. Please note that it’s still got to make sense for someone in your profession. For example, if you are a school teacher they are not going to believe you $250,000 per year. But people do make up numbers much larger than the real amount they make. It is not for nothing that stated income is often called a “liar’s loan”. That is fine and good, as long as you actually can make the payment. When you can’t it’s a real issue. Not necessarily for the loan officer, who’s going to get their money and depart the scene, and as long as you make the first payment or two they’re off the hook, but for you, the client. Keep in mind that as soon as the loan is funded, that loan officer is out of the picture whether you went through a direct lender or not, and they know it. That real estate agent is also out of the picture as soon as you have your house, and they know it. You’ve got to live with the situation they created, and they kind of know it, but in many cases it just isn’t important to them. So watch out, and shop around. The person who “pre-qualifies” you for the lowest amount may be the one you should do business with, because they are using assumptions you can actually live with. Go over their numbers with a calculator in hand.
The stated income loan leads into our next issue, which is that few people will expend the necessary effort to do a “pre-qualification” correctly. It takes several hours to do an accurate “pre-qualification” correctly, but a Wildly Assumptive Guess takes just a few minutes. You may imagine which is done more often. This especially applies if the agent does not run credit or does not get income documentation. Due to the availability of the stated income loan, they really don’t have a need to be accurate, and due to pressures to come up with high numbers, their assumptions are going to range from pretty optimistic to wildly optimistic. This is wonderful if you just want to be able to say you were a homeowner for a few months while the bank forecloses on you. It’s not so great if you’re trying to get into a survivable financial situation.
You may get the idea that when it comes right down to it, most “pre-qualifications” are convenient fiction, worth an approximately equal size of toilet paper, if not quite so soft. You’d be correct. So “Why are they so ubiquitous?” becomes the obvious question.
The answer is sellers and seller’s agents. Sellers are going to go through a significant amount of trouble and expense going through the motions of selling their homes. Furthermore, they can only have one proposed sale in process at a time and they may have a deadline. They understandably want some kind of reassurance that this buyer can actually qualify for the loan. For their part, seller’s agents can be some of the laziest people I’ve ever met when you come right down to it. They’ve paid the money for the advertising that draws people or joining the big well-known National Brokerage With Television Advertising! Once they get the signature on a listing agreement, many think they’re entitled to sit around with thumb you-know-where and wait for the commission to roll in. They don’t want to go over the buyer’s pre-qualification with the seller, and some of them have no idea as to how to do it. But they certainly don’t want to carry out their part for more than one proposed transaction, hence their desire for this Magical thing called the “pre-qualification.”
The correct way to respond to this concern, for a seller, is simple and yet many people think it’s hard-nosed. Require a deposit. Require it be remitted to you on the last day of escrow as part of the initial contract, whether or not the loan funds. Now the standard form in California, as a default, makes the sale conditional upon the loan for seventeen days, but this can be changed by specific negotiation. True, you might scare away some buyers who aren’t certain that they’re qualified, and in buyer’s markets this may scare them away entirely. But you won’t enter into escrow with anyone who’s unsure. You shouldn’t rely on a “pre-qualification”, which is basically just a piece of paper that’s now been filled up with useless markings and so can’t be used again.
Furthermore, many buyer’s agents, knowing how useless a “pre-qualification” is, don’t want to take the time to do them themselves and so tell their clients to go get one somewhere else, but that when the time comes they have someone who will do the actual loan. It didn’t take very long for the word on this practice to get out, and so loan officers and agents with a very short time in the business learn not to do them unless they are going to get something out of it. Which basically means control of the transaction or an upfront payment. I certainly can’t name anybody with more than a few months in the business who will do a “pre-qualification” unless a client either signs a Buyer’s Agent Agreement or pays them a fee or does something that assures them they will get a transaction. And if your agent says go get a “pre-qualification” on your own, go and get another agent. If they or the loan agent they recommend can’t be bothered, then obviously they are too busy to give you the necessary attention to get your transaction done properly and on time. It’s very hard to fight the system that requires a “pre-qualification,” no matter how useless it is, but it’s part of the work they signed on for. They should do it themselves.
Caveat Emptor
Updated Parameters for Solving Kelo
Back on July first, I posted Solving Kelo – Seeking Parameters for a Solution.
As I wrote then:
When you’re in my current profession, you can’t help but learn that public condemnation of private property for private use has a long and not entirely dishonorable history in this country. Yes, it goes back to 19th centruy crony deals of the sort Tammany Hall was famous for, but it has also been used to condemn farmer’s land for factories near cities where poor to middle class workers could get to them, clear blighted areas, and many other uses. It is sometimes necessary to avoid many times the cost, both to the beneficiaries and to society at large.
The clear and obvious problem with condemnation is that it is involuntary. Not much can be done about that. It’s one of those “by definition” things. But we can keep it in mind. On the other hand, most development by its very nature also requires ownership of a complete footprint, and designing around one or a few who are unwilling to sell at any price is usually prohibitive. In other words, if 499 out of 500 people in an area are willing to sell and the 500th is not, the 500th is imposing his will on the other 499, and the entity that is in the minds of that 499 their benefactor, to no less degree than the landholders in Kelo were imposed upon. The way to keep involuntary nature foremost is to make certain that the victim of eminent domain can come out no worse by objective measure than when the process started, and should be handsomely compensated for the involuntary nature of the condemnation, instead of being paid fifty to seventy-five cents on the dollar
the bullet points version of the parameters:
-overcompensate victims out of beneficiaries pockets
-the proposed beneficiary liable for victim’s legal costs
-victim must receive the clear price of a replacement
-victim deserves compensation for effort of defending
-moral issue – observer’s should not feel sorry for victim
-difficulty of amendment versus relative ease of law.
Additionally, I’ve seen one further issue since then, namely that New London wants to compensate Kelo et al based upon property value at the completion of the initial suit, rather than at the termination of appeals, and charge them rent to boot. Somehow I doubt New London is offering to refund property taxes or mortgage expenses incurred during that time. Furthermore, with property values so much higher now than then, the defendants in Kelo clearly will not have resources to purchase a replacement, in violation of bullet point three above.
I had originally posted a proposed solution Fixing Kelo – a proposal.
I must now conclude this falls short in two areas. First, the owner – the victim of involuntary condemnation – is not explicitly compensated for their time.
Second, it does not explicitly disallow New London’s tactics.
Therefore, I would like to amend my proposed solution to Kelo thus:
proposed new public law:
The Congress of the United States, wishing to discourage abuse of eminent domain, henceforth enacts into law:
- In the event of public condemnation of private property, the public entity bringing suit shall pay all expenses of the defending party in said suit, including but not limited to legal expenses, and any expenses incurred in evaluation of the property or documentation of this value. This compensation shall be immediately due and payable upon presentation of reasonable proof, and it shall accrue interest at a rate not less than double the prevailing customary rate, or additional charges incurred by the property owner as a result of tardy payment, whichever is greater. This compensation shall be paid regardless of the said suit’s resolution.
- The public entity bringing suit for condemnation shall compensate the defendents for time spend defending against the suit in the amount of their customary or normal professional compensation as determined by the higher of either normal compensation from an employer or proration based upon a 2000 hour work year and their gross income from their profession in the preceding year as filed with their federal income taxes. This compensation shall also be paid regardless of the outcome of the suit.
- In the event of a successful condemnation, the property owner shall be additionally compensated no less than the greater of either factor A of the fair value of the property determined in accordance with usual practices or factor B of the cost of replacement property. This evaluation shall be determined at the most favorable to the defendant of the following times: The time that the entity bringing suit takes possession of the property as determined by accomplishment of both transfer of title and vacation of the property by current tenants, or the time of purchase of replacement property. Additionally, the beneficiary shall pay all transaction expenses involved in the transfer of the condemned property and shall also pay all transaction costs of the defendant of a successful condemnation in acquiring a replacement property.
- In the event of a successful condemnation, neither rent nor property taxes shall be required of the defendants for any period at issue until 30 days after the conclusion of the final appeal.
Factor A and factor B in 3 above need to be set by societal concensus. I’d like to see factor A around 150 percent and factor B around 125 percent, but as long as factor A is at least 120 percent and factor B is at least 110 percent, I’ll be satisfied enough.
The Truth In Lending Statement and APR
The Truth-In-Lending is a form that can or does provide some useful information, but the useful information it provides is both smaller than most people think, and not in the numbers everybody looks at.
The first thing to be aware of is right below the title. “This is neither a contract nor a commitment to lend.” They are telling you right there that this is an estimate. It may or may not be a good estimate. That depends upon the loan officer and the provider they work for. Again, the relationship between this form at the beginning when you apply for the loan and the loan that is actually delivered with the final documents can be extremely tenuous.
The APR in the very first box is the result of an attempt by Congress to compress what is fundamentally at least a two-dimensional number into one linear measurement. It is intended to help give you a direct, one number measurement of the effective interest rate, given the expenses. But, in order to this it has to make some assumptions
The first of these is that you’re never going to sell. Back in the early 1970s with stable secure jobs for a large portion of the populace not only in government but in private industry as well, and people living their whole lives in their first house, this was a reasonable assumption. No longer. The median time for ownership duration is about nine and a half years.
The second of those is that you’re not going to refinance. This also was not an unreasonable assumption back in the early 1970’s. Our habits as a society have changed since then. The fact is that the median age of mortgages (half older, half younger) is currently about two years. Only something like 4 percent of all mortgages are older than 5 years. I’ll have other implications of these facts later, in other essays.
But by making this assumption, that you’re never going to sell and never going to refinance (again, for the fifth time) and just make that minimum payment every month for thirty years, it allows the illusion that you’re going to spread those costs out over thirty years, when the appropriate time frame is much shorter. This is a dangerous illusion. To give a specific example, because it means that, when measured by APR, a 5.5% loan with closing costs plus two points looks like a better loan than a 6 % loan with closing costs but no points. In fact, it is quite likely that the 6% loan is a better idea, and a 6.5% loan where the lender pays your all of your closing costs for you may be better yet.
Let’s go through the calculation involved. Assume they’re both thirty-year fixed rate loans, so you’ll actually keep getting benefits as long as you keep the loan. Assume the base loan we’re looking at is $270,000, the same figure I’ve used elsewhere. This can be either an existing loan, or a purchase where you need $270,000 beyond your down payment to cover purchase price and costs of buying.
As we computed in looking at the Good Faith Estimate, the closing costs of doing this loan are somewhere in the neighborhood of $3400 or so. But “third party” costs, such as escrow and title, are excluded from APR calculation, so we’re going to deduct about half of that, or $1700, from them when we calculate APR. I’m also going to assume that you actually pay all of your “prepaid” and “reserve” items out of pocket, which keeps things simple. Your actual loan amount in the case of the 5.5% loan with two points is $278,980, and your monthly payment is $1584.02. Your actual loan amount in the case of the 6% loan is $273,400, and your monthly payment $1639.17. The third loan has a payment of $1706.58 on a balance of $27000 even. The APRs (a complex calculation) work out to 5.742, 6.059, and 6.500 percent, respectively. Looks like the first is a better bargain, right?
Your actual interest expense the first month is $1278.66 the first month for the first loan, $1367.00 for the second. This is a difference of $88.34, and this number is actually going to increase for the first several years of the loan. The rest of the money is a principal payment. Equity. Money you don’t owe anymore. The principal paid the first month on the first loan is $305.36; on the second is $272.17, a difference of 33.19 the first month in the first loans favor. For the third loan $1462.50 represents interest and only $244.08 is principal. This is really looking like you make the right choice with 5.5%, correct?
But let’s look at two years from now – about the age of the median mortgage. I’m going to use the loan in the middle as baseline.
Loan 1 Loan 2 Loan 3
Interest paid $30,288.21 $32,418.26 $34,720.18
Principal paid $7,728.21 $6,921.84 $6,237.83
Remaining balance $271,251.79 $266,478.16 $263,762.17
Diff in interest paid: $-2130.05 $0 $2301.92
Diff in balance: $+4773.36 $0 $-2715.99
Net $ to you $-2643.31 $0 $+414.07
Loan 1 has paid $2130.05 less in interest, and $806.37 more in principal than Loan 2. Looks great, right? But they also paid $5580 more for the loan, or which $4773.36 remains on their balance. Remember, fifty percent of the people have sold or refinanced at this point. When you sell or refinance, The Benefits Stop. But the cost is sunk. You paid it in full two years ago. And at this point if you sell this home, you will actually get $4773.36 less in your pocket than in if you had taken the 6% loan. This is somewhat compensated for by the fact that you spent $2130.05 less in interest expense. But you’re still $2643.31 down as compared to the 6%, and there’s no way around that. Meanwhile, the 6% loan itself lags the 6.5% loan by $414.07 at this point in time.
And if you refinance, it gets even worse. You’re now paying interest on the $4773.36 in higher balance for the rest of the time you’re got your home. Let’s say the rate is 5% now because you got an even better deal. This means $238.67 per year, $19.89 per month extra that you’re going to pay for as long as you have that loan, all for benefits that you don’t get anymore and never paid for their costs in the first place. This is truly the gift that keeps on giving, isn’t it?
Now let’s look 5 years out, when over 95% of the people will have sold or refinanced.
Loan 1 Loan 2 Loan 3
Interest paid $74,007.65 $79,360.88 $85,144.66
Principal paid $21,033.41 $18,989.39 $17,250.36
Remaining balance $257,946.59 $254,410.61 $252,749.63
Diff in balance: $+3535.98 $0 $-1660.98
Net $ to you $+1817.25 $0 $-4122.80
At this point for loan 1, you have saved $5353.23 in interest and paid down $2044.02 more in principal, right? Yes, but you paid $5580 more for the first loan than you would have for the second, and you still owe $3535.98 of this difference. If you sell, you will get $3535.98 less to put in your pocket, although that will be more than balanced out by the interest you saved. Net profit to you of choosing the first loan: $1817.25, neglecting tax treatment. Boy did you make the right choice, right? But remember that over ninety five percent of everyone who made the same choice you did never made it to this point. Furthermore, if you’re like most people and you intend to buy some other property where the transaction includes a loan, that loan will have a starting balance $3535.98 higher to start with than if you’d chosen loan number 2 in the first place. Assume you got a great rate on your new home: 5% even. This means you’re now paying $176.80 per year in interest that you wouldn’t be paying if you’d simply chosen Loan 2 in the first place. Assuming you intend to own property for the rest of your life, in a little over ten years your gain is gone.
On the other hand, you are doing safely doing better with loan 2 than 3 at this point. The difference in interest you’ve paid has more than made up for the difference in starting balance. Whether you refinance or sell, it’s going to be difficult to make up $4122.80 with the interest based upon 1660.98. Assuming 5%, this is $83.05 per year it amounts to 50 years to recover. Loan 3 shows up pretty well against loan 1, though. $5196.96 difference in balance times 5% per year is $259.85. Divide the $1479.49 by this number and get that in 5.69 years, your benefits from loan 1 as opposed to loan 3 will be gone.
Now, if you get a great deal and refinance instead of selling, that extra $3535.98 that you still owe on that mortgage is still there, and will be for as long as you own that home. Assume you got a really great deal of 5%. This means $176.80 per year of extra interest expense – just from the fact that your balance is higher because of sunk costs to pay for benefits that have stopped. Assume you keep your home another five years, so altogether you’ve had it ten years since the initial loan. This has cut your gain to $933.25.
This happens all the time. It is not uncommon for me to talk with people who bought their homes in the 1970s, have refinanced ten or twelve times, and now owe more than ten times their original purchase price, a good portion of which is directly attributable to unrecovered closing costs of the refinances. Here’s the point: closing costs and points stick around, sometimes a long time after the benefits you got from them are gone, and people refinance or more often than most people admit. The only loan that CAN be ahead from day one is the true zero cost to the consumer. Everything else will pay for itself eventually, and more than pay for itself if you hang onto it long enough, but you’re sinking a significant amount of money in the bet upfront, money which is going to be around in your balance a long time. Furthermore, people don’t hang onto these loans as long as they think they will, and very few people hang onto them long enough to see profits from high closing cost loans. Finally, the rate at which a zero cost loan can be done varies from day to day, and by quite a lot over time. Let’s say six months from now I can do a 6% loan no cost. It costs you zero, and now if you’re loan 3, you’ve got the same loan at a lower balance than the guy who chose the 6% loan 2 above, whom I can’t necessarily help right now.
Then three years down the line, rates really drop, and I can do 5.5% for no cost. A call to both loan 2 and loan 3 nets borrowers who are eager to cut their rate for zero cost, but I still may not have anything that helps 1 in the sense of being worth the cost of doing it. Now loan 1, loan 2, and loan 3 all have the same rate, but loan 3 owes the least amount of money, therefore has the lowest payment, and has the most equity in their home.
Here’s another dirty little not very secret, but rarely publicly acknowledged, fact: People don’t always refinance into a lower rate when they refinance. If you’ve been a homeowner 15 years or so, chances are reasonable that you’ve done it – possibly more than once. Don’t worry, I’m not going to pillory you in public over it, but if you won’t admit it to yourself then there’s not a lot that can be done for you. People have various reasons for refinancing into higher rates, some of them reasonable, some of them relating to necessity, and some quite frivolous. But you’d be amazed at how often people looking to refinance expect me to believe stories that numbers show to be obvious fiction about how often they’ve refinanced a property. This is math, and if the numbers tell me you’ve been making payments on this loan for two years when you tell me five, I’ll bet millions to milliamps that if I go check the public records that are maintained on every piece of real property in the country I’ll find that Trust Deed recorded two years ago. Now, it’s okay to tell some lies of certain kinds to your loan officer, and assuming that any prepayment penalty has expired, this is probably one of them. No harm, no foul. What a typical loan officer cares about is getting paid, and if you’re withholding or correct information doesn’t make a difference to that, there’s been no harm done. A good loan officer will add, “Putting the client into a better position” to that first, paramount concern, and if the information you withheld would have resulted in a different answer to this question, you have only yourself to blame. (Looking for altruists in business is both pointless and hazardous to your financial health. Businesspersons donate huge amounts of time and money and energy to charities or other works for the public good. But we’re at work to Make Money. I am very good at what I do and getting better because I want to Make More Money, and mistakes do the opposite of Make More Money). But you need to be completely honest with that wonderful person you see in the mirror every day who follows you around twenty-four hours every day, shares in all of your triumphs and joys, and has to deal with all of your mistakes for the rest of your life. Otherwise you’re going to waste a lot of money on mortgages making the same mistakes over and over again.
Getting back to the actual Truth-In-Lending form, finance charge assumes you keep the loan the full term, as I have explained. Amount financed is subject to the same limitations as the Good Faith Estimate, and in fact assumes that the Good Faith Estimate is honest and accurate. So is the Finance charge. Neither of these, nor the Total of Payments, which is simply the sum of these two, is any more valid than the Good Faith Estimate this form is based upon. Do NOT use the Truth-In-Lending as a way to compare loans, numbers-wise. Many people do precisely this because it’s such a simple looking, easy to understand form. But if it’s based upon a Good Faith Estimate that’s not valid, it means nothing. Zip. Nada. Garbage In, Garbage Out.
Nope, the minimal information provided by this form is in the details that start about halfway down.
Demand Feature: If checked, this means the lender can require that you repay the loan in full, with a certain number of days (usually 30) notice. It can also mean there’s a balloon on the loan.
Variable Rate Feature: if checked, this means that at some point, if you keep the loan long enough, become a variable rate loan. I’ve seen loans that went as long as ten years before a variable rate kicked in.
Credit Life and Credit Disability are two products that I would generally recommend against unless it’s the only life or disability insurance you can get. Some states do not permit them to be a requirement of the loan – and in those cases where the lender would otherwise require one or both, you won’t get the loan as a result. (On the other hand, without these state prohibitions, many lenders would require them much more often, costing consumers in the aggregate billions. Just like everything else in mortgages, it’s a tradeoff with winners and losers no matter what you choose.) Both of these products typically pay any benefits directly to the lender, when you want them to come to you or your family. Buying your own life insurance or disability insurance is typically a much better idea.
Property and Flood Insurance The lender can and will require you to maintain proper insurance on the property as a condition of your loan. In California, they cannot require this be for the full amount of the loan, but they can and will require you to maintain coverage for the amount of full replacement costs – what it would take to rebuild your property as it is from the ground up. Many lenders delegate the responsibility for making sure this is done on their behalf to big administrative operations that cover the whole country, and they are ignorant of individual state law even for such major states as California. Be polite, but firm, when they tell you they are looking for coverage in the full amount of the loan. Flood insurance is a separate policy that can also be required if the property is on a flood map. The lender can either demand your loan in full immediately or purchase insurance on your behalf and force you to pay the bill if you fail to show them continuing proof of adequate coverage.
SECURITY: The first box should be checked for purchases, the second for refinances. In rare cases I do see somebody taking out a loan on a home that is free and clear to get a better rate than they would on a new property they’re buying, because they’ll get a better rate that way. In this case, the second box should be checked.
Filing Fees are for filing the papers with the county recorder, and should be the same as listed on the Good Faith Estimate
Late Charge basically discloses what your penalty for any late payments will be. It is expressed as a percentage of your normal monthly payment.
Prepayment penalty: Should tell you honestly whether there will be a prepayment penalty on the loan, but often doesn’t. Says nothing about the duration of it. Forget the second line. All of the costs to get you the loan are sunk and nonrefundable from the time you sign the papers. All of the interest that you pay as it is due is gone forever. You’ll never see it again. They earned it. They’re not going to give it back. I’ve never heard of a loan where in the initial contract the borrower was promised a rebate of part of those costs if they paid off early. Banks did make a lot of offers to discount loans if you paid them off in the late seventies and early eighties, but these were offers made at a later time, long after loan papers were signed, by the banks because they were losing their shirts buying money at 14% or so when it was already loaned several years earlier to customers at 6%. It wasn’t a part of the contract in the first place.
Assumption: This means that if you sell the property, the buyer can keep your loan in effect. The VA loan is the only one out there that is generally assumable by the buyer if you sell, but there are some other loans that are assumable as well. It’s not usually a good idea to let them, but there may be no alternative. The reason: You can still be liable for these if you do allow them to be assumed.
Then there’s a line where there are two final square boxes to check, where “* means an estimate” and “all dates and numerical disclosures except the late payment disclosures are estimates. Expect the second box to be checked. It’s all based upon the Good Faith Estimate. If they’re stretching the truth there, the numbers here are going to be similarly distorted. And if it’s not checked, that’s “an inadvertent oversight” and unlikely to be prosecuted. Which is as it should be – unless there’s a pattern of it, which is the case with all too many loan providers.
Caveat Emptor
The Negative Amortization Loan
I am not exactly certain how to start this essay. I’m kind of in a position analogous to writing Hitler’s biography in late 1940. We know at this point he’s a miserable excuse for a human being, but we don’t have the evidence discovered in the last four and a half years of the war as to how sick he truly was.
The negative amortization loan is something very similar. With Chairman Greenspan and even the heads of many building companies talking about locally frothy real estate prices, we are pretty certain that there’s going to be a drastic re-evaluation of the home market soon. We are missing the data of exactly how bad it’s going to be.
The negative amortization loan, with all its friendly sounding synonyms (Option ARM, Pick Your Payment, 1% loan, and variations and combinations thereof), is an idea that comes around periodically, and right now happens to be one of those times. Last time was the mid 1980s, and we had people driving their cars through the lobbies of savings and loan buildings in protest after they got hit with this loan’s GOTCHA! If you see ads on the Internet or elsewhere advertising “$200,000 loan for $650 per month!” (or something similar) one of these abominations is what they’re trying to hook you with.
These loans look, at first glance, to be wonderful – too good to be true. That is because they aren’t true. Furthermore, given the fact that loan officers and real estate agents want to get paid, and the damage isn’t apparent to the average consumer until well down the line, the unscrupulous ones sell a lot of these. I can point to loan and real estate offices where they do no other kinds of loans. Why? Because given the fact that most people shop for a loan or a home based upon the monthly payment, these are the easiest loans in the world to sell, and how many homes do you usually buy from a given real estate agent anyway? Cash flow is important, but watching only cash flow ends up in Ponzi schemes, Enron, and negative amortization loans.
I want to make very clear that yield spread is not a reason not to do a given loan. If a loan officer shops around and does the work to qualify you for a better loan on the same terms while increasing their compensation, they deserve to be paid that money. But you need to make certain that it IS a better loan by making an apples to apples comparison based upon what you, the client, are actually getting. For example, if one provider is getting you a loan at 5.5%, that looks to be better than 6.5% at first glance, correct? But if the first loan is only fixed for two years, and has two points on it as well as $4000 of closing costs and a five year prepayment penalty, while the second loan is fixed for thirty years and the lender is paying all of your closing costs with no prepayment penalty, I submit that the second loan is the better loan in most circumstances. The negative amortization loan, piece of garbage that it is, compares favorably with no other loan available today. The yield spread varies between three and four points on these things, with most of the lenders tending towards the higher end of that spectrum in order to compete. To give you a comparison, in order to get four points of yield spread on any other type of loan, I have to give people an interest rate at least two full percent higher than the going rate!
Basically, what this loan does is give you three or four options for your payment every month. The lowest of these is the bank allowing you to make a payment as if your interest rate was somewhere between one and two percent, with most of them now congregating towards the lower end of the spectrum in order to compete with one another. This low rate of 1% or so IS NOT YOUR REAL RATE. IT IS NOT WHAT YOU ARE ACTUALLY BEING CHARGED! I don’t know how many people I’ve talked to that were being taken for a ride and asked me, “Isn’t there any way this is the real rate?” THE ANSWER IS NO. Let’s pretend you are a bank officer. Remember, you’re one sharp person, and you have another whole group of very sharp people watching what you do. If for an equivalent amount of risk, you can get about 7 percent somewhere else with a different investment, are you going to give some poor sap I mean someone you don’t know a 1% loan that messes the heck out of your quarterly usage of capital bonus? Not on planet Earth.
The second payment option will be to make a payment based upon an interest only loan at the real rate you are being charged. I’ve seen the piranha that sell these loans trying to prey on each other extolling the virtues of COFI or MTA loans, depending upon which they have. The fact is that they’ve each got their limitations, and their upsides and downsides as opposed to the other. The problem with each and every one of these is that they are month to month variable from the beginning. There is no fixed period. You will never know next month’s rate until it happens. Thus far in my career, I’ve always had loans that are fixed for three to five years, at rates lower than this rate that the loan is really charging you. In other words, this second payment option is based upon a rate that changes every month, based upon the movement of an underlying index plus a margin.
The third payment option is to make a fully amortized payment based upon that same month-to-month rate. This is roughly analogous to a standard thirty-year loan, except that it is not fixed, and unless you make a payment of at least this much, next month’s payment options are going to be worse. The fourth and final payment option given by most lenders who do these is for the client to make a fifteen-year payment. Before we move on, the point needs to be made that almost nobody actually makes the payment for either of these options, much less makes these payments habitually as opposed to the other options. These payments are higher, and are not good selling points for this loan. If the client could afford to make these payments, there are better loans to be had. This is a metaphorical fig leaf to cover their naked taking advantage of you. “Well, he could make (or could have made) this payment but didn’t. It’s not my fault.” The reason they didn’t make the payment, Mr. Unscrupulous Realtor, is because YOU told them they didn’t have to. You SOLD them the house based upon the nominal payment, not the real cost.
Now, what happens if you make each of these payments? Obviously, if you make the payment for either the third or fourth option, you are paying your loan down. If you make the payment for the second option, that is basically a break-even, except that next months payments will be computed based upon one fewer month with which to pay the loan off.
What happens for 95 percent of the people who do these loans 95 percent of the time is they make payment option one. What happens in this case, where the client is making a payment that is less than the amount of interest on the loan for that month? The bank isn’t going to just eat the difference. That interest has to go somewhere.
Where it goes is into the balance of the loan. This means the balance for your loan – the amount you owe the bank – goes up every month that you make this payment option. Furthermore, next month it earns interest also. Next month the difference between what you pay and what you are charged gets higher, and even more money is applied to your loan. You’re being bit by compound interest. This is the first reason why the lenders will pay loan officers who do these loans so much. The lender knows that in the vast majority of all cases, the clients will end up owing them more money than they originally borrowed.
Furthermore, every single one of these loans that I know of has a three-year prepayment penalty. This means that even after you figure out that you’ve been taken for a ride, you’re either still stuck with them for the rest of three years or you’re going to pay a penalty amounting to thousands of dollars. Not a bad position for a lender to be in for leading you down the primrose path, is it?
I haven’t even gone over recast provisions (the 1% rate, even though it’s nominal, not real, doesn’t last forever), and various other lurking GOTCHA!s. I hear a lot of arguments from the various lazy lowlifes who make a habit of doing these loans rationalizing what they’re doing. “Those old loans had no cap. Now there’s a nine percent cap” If the client could afford six percent, there are other better loans to be doing. “They’ll more than make up for it in increased equity as prices rise.” A) Maybe, IF the market continues to rise, which is doubtful at the current time and never something you should bet other people’s financial health upon. It’s a crapshoot, at best, and the prevalence of these loans is one reason why the market is so overheated. In any event, the client is going to end up owing more money. Unless they’re going to sell and not be a homeowner any more, they’re going to have to pay the loan sometime, and in the meantime the longer they keep it, the worse it gets. What happens in three years if home prices are lower and the loan gets recast and now they cannot refinance out of it? “It’s the only way to get them into a home!” They still end up owing more money, and it’ll keep getting worse the longer they keep the loan. They’re still going to need to pay it back, unless they sell, and sell at a sizable profit. Furthermore, if they couldn’t afford a reasonable loan in the first place when they needed to borrow $X, what makes you thing they’re going to be able to afford a reasonable loan three years down the line when they owe $Y more. This is not a stable, sustainable situation! Maybe in a case like this, they should continue renting. Of course, that doesn’t get you a commission, does it, Mr. Unscrupulous Realtor? It certainly doesn’t encourage the client to stretch beyond their means and get you a bigger commission, either, does it?
For any loan officer who does these reading this, face it: These things are a way to mess up your client who is putting money into your pocket. These put the clients into worse situations than when they started. You are betting upon factors beyond your control to save you. One of these days, probably very soon, these are going to come back and bite you hard. Violation of fiduciary duty. All it takes is one of your clients getting into a bad situation who gets a good lawyer, and your career is toast along with your pocketbook.
For those of the general public reading this, I hope I’ve opened your eyes to some of the pitfalls of this loan. I’m perfectly happy to answer questions if you have them. But this loan is one that is designed for a narrow set of circumstances tailored around cash flow for a limited amount of time (and the one time I actually had a client who was the target market and who could actually benefit from this, none of the companies I submitted it to would approve it). It is abused by being misapplied because it’s such an easy loan to sell to those who do not understand the way they work, and all because people shop for a loan based upon payment. So don’t shop for a loan based upon payment. And if anyone offers you one of these loans, drag them into the sunlight, drive a wooden stake through their heart, and RUN AWAY! Somebody who offers you one of these is not your friend.
Caveat Emptor